Dividend Discount Model. Integrated Potato Chips just paid a $1 per share dividend.
You expect the dividend to grow steadily at a rate of 4% per year. (LO7-2)
a. What is the expected dividend in each of the next 3 years?
b. If the discount rate for the stock is 12%, at what price will the stock sell?
c. What is the expected stock price 3 years from now?
d. If you buy the stock and plan to sell it 3 years from now, what are your expected cash flows in (i) year 1; (ii) year 2; (iii) year 3?
e. What is the present value of the stream of payments you found in part (d)? Compare your answer to part (b).
a. Expected dividend in next three years:
Dividend growth rate=4%=0.04
D1=Expected dividend next year=1*(1+0.04)=$1.04
D2=Expected dividend in year 2=D1*1.04=$1.0816
D3=Expected dividend in year3=D2*1.04=$1.124864
.b Discount rate=12%=0.12
Market price of the share=D1/(R-g)
g=Dividend growth rate=0.04
Market Price of Share=1.04/(0.12-0.04)=$13
.c. Expected stock price after three years=P3=D4/(R-g)
Stock price after 3 years=P3=1.169859/(0.12-0.04)=$14.62323
.d. (i)Cash flow in year 1= Dividend D1=$1.04
(ii)Cash flow in year2=Dividend D2=$1.0816
(iii)Cash flow in year 3 =D3+P3=1.124864+14.62323=$15.7481
.e. Present value of stream of cash flows=(1.04/1.12)+(1.0816/(1.12^2))+15.7481/(1.12^3)
Present value of stream of cash flows=$13.00
The amount is same as present market price of share calculated under .b ie $13